'Too Big to Fail' for Banks Not Solved Yet: Fed Gov. Tarullo

In an exclusive live interview, Federal Reserve Governor Daniel Tarullo tells CNBC's Steve Liesman there's still more work to be done to make sure no bank's failure can bring down the entire financial system.

The problem of banks being "too big to fail" has not been solved yet, Federal Reserve Board Governor Daniel Tarullo told CNBC on Wednesday.

Tarullo said in a "Squawk Box" interview that if a big bank were to be on the brink of failure today, he does not think taxpayers would be on the hook for a bailout.

"But I don't think anyone can be assured of that now," he hedged, "because this is a process. It's not a binary matter of a bank being 'too big to fail' or not, I think it's a process of building up capital of the FDIC ... and [the Fed] addressing issues of funding."

Tarullo—who came to the Fed after serving as an economic adviser on President Barack Obama's 2008 campaign—said important steps have been taken to "reduce the phenomenon of 'too big to fail'—such as increases in capital, (and) the creation of special liquidation authority for the FDIC." He noted, however, that "there is more to be done."

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Daniel Tarullo, governor of the U.S. Federal Reserve.

The question of whether banks should be broken up is up to Congress, Tarullo said, noting that lawmakers should also "talk about the proposal that would put caps on the non-deposit short-term liabilities of banks." He added, "That's consistent with my view that that's a big vulnerability."

Absent congressional action, however, the Fed under the Dodd-Frank reform law has the authority to put in place liquidity requirements, and Tarullo—also head of the Fed's banking regulation panel—said the central bank should pursue "increasing stringency" of those requirements.

The 'London Whale'

In the case of the so-called London Whale losses at JPMorgan, Tarullo said it wasn't a failure of oversight, stressing "we have to recognize that one thing that was the case at JPMorgan—and it's true at all of our large banking institutions today—is capital levels are much higher than they were four or five years ago."

"And thus," he continued, "the capacity of these firms to absorb losses, whether they come from conventional credit losses or from an operational problem or from something else, is just substantially greater."

Had the long-delayed "Volcker Rule" to restrict certain kinds of speculative trades been in place, JPMorgan would have been required to document why what it was doing was hedging, Tarullo argued.

"At the very least, there would have been a series of moments at which people had to really say: 'Is this a hedge?' 'What is the hedging strategy?' 'Does it create new risks?'"

He explained that he doesn't have a litmus test for when quantitative easing should end, but he pointed out as a guide the standard of the Fed policymakers, which calls for a "substantial improvement in the outlook for the labor market."

"What I'd like to see is some good healthy peaks that have job creation well above the rate of new entrance into the labor market," he continued, "followed not by valleys ... but at the very least, by a nice plateau that can be the basis for some more peaks later."